The Commonwealth of Puerto Rico offers lucrative tax breaks that are designed to attract high-net-worth individuals and businesses to the island and boost its local economy. Under the Puerto Rico Incentives Code of 2019 (also known as Act 60), individuals can avoid taxation on Puerto Rico-sourced income if they “reside” on the island for a majority of the year and make certain economic contributions to the territory. Act 60 also offers significant tax advantages for businesses that are located in Puerto Rico but provide services to customers located elsewhere, including a fixed income tax rate of 4% and a total tax exemption for distributions from earnings and profits.
Given the significant tax benefits of relocating to Puerto Rico, it should not be surprising that the Act 60 incentive program is susceptible to abuse. In recent years, the Internal Revenue Service (IRS) has stepped up enforcement against individuals and businesses that may be illegally claiming Act 60 incentives, which subjects all taxpayers relying on Act 60 incentives to greater scrutiny.
Because Puerto Rico is a U.S. territory rather than a state, it has the freedom to craft its own tax regime. Act 60 consolidated and updated prior tax breaks, including Act 20 and Act 22, which were enacted in 2012. It provides a range of incentives targeting individual investors, businesses, manufacturers, international financial entities, private equity funds, and others. Each incentive has its own requirements and benefits.
Act 20, also known as the Export Services Act, offers tax incentives for companies located in Puerto Rico that export services to other jurisdictions. The tax benefits on income derived from customers outside Puerto Rico in relation to services rendered from Puerto Rico included a fixed income tax rate of 4% for eligible export services, along with other tax benefits.
To take advantage of the tax incentives, businesses must have a “bona fide” office or establishment in Puerto Rico and conduct eligible services as an export service provider or an export commerce business. In addition, export services can't have a connection with Puerto Rico and services must be rendered to a foreign natural or juridical person located outside of the territory.
If eligible, businesses can reap significant benefits, which include:
- Business volumes of over $3 million are generally subject to an income tax rate of 4% on net income derived from the exempt operation;
- Distributions of dividends or profits generated by the exempt operation are 100% exempt from Puerto Rico income tax;
- Exempt businesses with a business volume of over $3 million are entitled to a 75% exemption from personal and real property taxes.
- Exempt businesses with a business volume of over $3 million are entitled to a 50% municipal license tax exemption.
Tax exemptions under Act 20 last for 15 years; however, they can be extended for an additional 15 years.
Pursuant to section 933 of the U.S. Internal Revenue Code, bona fide residents of Puerto Rico are not subject to federal income taxes on Puerto Rico source income; however, they continue to be subject to federal income taxes on income that is sourced outside of Puerto Rico, including the mainland United States. So, if you're a bona fide resident of Puerto Rico, you generally aren't required to file a U.S. federal income tax return if your only income is from sources inside Puerto Rico.
Act 22, also known as the Act to Promote the Relocation of Individual Investors to Puerto Rico, grants new residents of Puerto Rico a 100% tax exemption from Puerto Rican income taxes on all dividends and interest. In addition, individual investors are eligible to receive Puerto Rico income tax exemptions on capital gains stemming from the sale or exchange of securities that appreciated in value after the individual establishes domicile in Puerto Rico.
For individuals to take advantage of tax benefits, they must be a bona fide resident of Puerto Rico. Generally, you are a bona fide resident if, during the tax year, you: meet the presence test; do not have a tax home outside the relevant territory; and do not have a closer connection to the United States or to a foreign country than to the relevant territory.
If you are a U.S. citizen, you will satisfy the presence test for the tax year if you meet one of the following conditions.
- You were present in the relevant territory for at least 183 days during the tax year.
- You were present in the relevant territory for at least 549 days during the 3-year period that includes the current tax year and the 2 immediately preceding tax years. During each year of the 3-year period, you must be present in the relevant territory for at least 60 days.
- You were present in the United States for no more than 90 days during the tax year.
- You had earned income in the United States of no more than a total of $3,000 and were present for more days in the relevant territory than in the United States during the tax year. Earned income is pay for personal services performed, such as wages, salaries, or professional fees.
- You had no significant connection to the United States during the tax year.
To receive an exemption, individual taxpayers must also make an annual donation of a minimum of $10,000 to local nonprofit entities certified under the Puerto Rico Internal Revenue Code. Puerto Rico also requires the individual to purchase residential property within the first two years of becoming a resident.
In recent years, the IRS has stepped up scrutiny of taxpayers who take advantage of Puerto Rico's significant tax breaks and has brought enforcement actions against those who fail to satisfy Act 60's legal requirements. Among other issues, investigators are looking into whether taxpayer have been truthful about how much time they spent on the island and the source of their income.
In 2021, the IRS announced a compliance campaign that focused on Act 60. Last year, the agency announced that it had identified approximately 100 individuals, including crypto traders and fund managers, who were suspected of illegally claiming Puerto Rico's tax incentives. According to the IRS, its ongoing enforcement efforts involving Act 60 include both civil audits and criminal investigations.
Given the serious civil and criminal penalties associated with federal tax fraud allegations, taxpayers relying on Act 60 should verify that they are in full compliance before the IRS comes calling. Similarly, if you are seeking to relocate to Puerto Rico to benefit from its tax incentives, we encourage you to consult with experienced counsel to properly structure your move.
At Scarinci Hollenbeck, our experienced tax attorneys work closely with clients to develop tax planning and asset protection strategies that achieve their goals. Our team also includes experienced tax defense attorneys who are prepared to aggressively defend our clients' rights should they face an IRS audit, enforcement action, or criminal investigation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.